David Freud, an investment banker hired by James Purnell, the new Work and Pensions Secretary, said the disability tests used to award state aid were "ludicrous" and could be costing billions of pounds.

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But he said the Prime Minister plans to press ahead with the biggest shake-up of the welfare state since its creation more than 50 years ago.

More than 2.6 million people claim incapacity benefit at a cost of more than £12 billion a year to the taxpayer.

However, Mr Freud suggested that less than a third may be credible recipients while several hundred thousand work illegally on the black market.

"When the whole rot started in the 1980s we had 700,000 [claimants]," he said. "I suspect that's much closer to the real figure than the one we've got now."

Although it is impossible to quantify exactly, this means as many as 1.9 million people who are able to work could be claiming the benefit.

Mr Freud - who has also influenced Tory welfare reform policies - launched a damning attack on the system that allows people to claim benefit, worth up to £81.35 a week. "If you want a recipe for getting people on to IB we've got it," he said.

"You get more money [than unemployment benefit] and you don't get hassled, you can sit there for the rest of your life. It's ludicrous that the disability tests are done by people's own GPs - they've got a classic conflict of interest and they're frightened of legal action.

"The system sends 2.64 million people into a form of economic house arrest and encourages them to stay at home and watch daytime TV. We're doing nothing for these people.

"You don't need to make a huge fuss about categorising people. If you're disabled, work is good for you and not working is bad for you.

"The people who are really disabled are often the ones who are really desperate to work, but there are then a whole load of people who say they don't want to be made to work regardless."

Successive governments have been accused of failing to clamp down on fraudulent incapacity benefit claims and critics say the fall in the number of unemployed may simply reflect people moving on to sickness benefits.

Recent figures showed that more than 500,000 people under 35 claim incapacity benefit with tens of thousands of people claiming for conditions such as depression, anxiety, and obesity.

Mr Freud estimates that "five to seven per cent" of claims are fraudulent with people working on the black market while receiving benefits.

Under his review, the private sector is to be brought in to run large sections of the welfare system and lone parents will be encouraged to work as soon as their children go to school.

People refusing to co-operate and find a job will have their benefits "sliced" under the plan to get about 1.4 million people back to work. The system should be in place within five years, he said.

Private companies will be put in charge of finding jobs for the long-term unemployed. They will be paid by results, with large fees if they succeed in keeping people in work for more than three years and nothing if they do not.

"We can pay masses," Mr Freud said. "I worked out that it is economically rational to spend up to £62,000 on getting the average person on incapacity benefit into the world of work."

He said there had been a transformation in the Government's approach to welfare since Mr Purnell's appointment. "Purnell is showing astonishing energy - there is going to be a much more single-minded ferocity".

Peter Hain, his predecessor, had been more "worried about the Left". The Conservatives and the Liberal Democrats already support the plans.

However, many of the Government's plans to return people to work may be derailed by fears of a recession.